Hedge Fund Uses CDO Magic to Transform Fannie Mae Junk Debt

  • Bayview borrows against Fannie Mae, Freddie Mac CRT notes
  • Asset-backed deal could be duplicated by other managers

A Florida hedge fund transformed risky Fannie Mae and Freddie Mac debt into investment-grade securities, and it could end up helping the mortgage giants’ efforts to offload more of their risk.

Bayview Financial packaged junk-rated securities issued by the two government-backed companies into $118 million of new bonds last month that Fitch Ratings stamped with grades as high as A-. The sale allows the hedge fund to borrow against its investments in the mortgage debt, giving it fresh funds to buy more assets to boost its returns. If other investors can do the same, it may increase demand for Fannie and Freddie’s riskier mortgage bonds, said Burt Weiss, a money manager at Semper Capital Management.

"There may be more of these deals," Weiss said, adding that these sales could be an effective way for funds to get financing. Semper Capital oversees $1.2 billion.

The debt that Bayview bundled into bonds is among $36 billion of credit-risk transfer notes that Fannie Mae and Freddie Mac have issued since 2013. While that’s a tiny part of the $6 trillion of safer mortgage bonds issued by the nation’s government-backed mortgage finance companies, the risk-transfer instruments are a key part of the government’s efforts to make U.S. homeowners less dependent on taxpayer-backed financing.

‘Critical Differences’

Bayview’s sale has some resemblance to collateralized debt obligations, the securities that turned toxic subprime mortgage bonds into top-rated debt and helped inflate the U.S. housing bubble. But the new securities have critical differences from their predecessors, and Fitch had to use a different way to assess them, said Grant Bailey, an analyst at the firm. Without that shift, the grades for the top-rated notes might have been four or five steps lower, Bailey said.

"It’s technically a CDO," Bailey said. But "we didn’t think the CDO methodology made sense here." For one thing, there were fewer bonds packaged into Bayview’s deal than would be in a typical subprime CDO, which made loss estimates easier to fine-tune, he said.

The credit risk transfer bonds that Bayview bundled into its securities are backed by home loans to prime borrowers, meaning the underlying loans are relatively safe. But if borrowers start to default, the notes from Fannie Mae and Freddie Mac may not be safe-- they are among the first to take the losses. With standard government-backed mortgage bonds, investors don’t take principal losses if homeowners stop paying their loans. Bank of America Corp. lead underwrote the Bayview securities, and declined to comment.

Few Alternatives

The notes look simpler and more transparent than CDOs, said Anthony Sanders, a finance professor at George Mason University and former head of mortgage bond research at Deutsche Bank AG. But their performance could depend a good deal on the housing market, and whether prices fall. 

"The housing market has had a massive inflow from foreign buyers, and if that suddenly stopped, we might have a problem,” Sanders said. Bayview, an asset manager based in Coral Gables, Florida that manages about $11.2 billion of mortgage bonds and other assets, said that the underlying debt had shown strong performance.

There have been far fewer mortgage bonds sold without government backing in the years since the housing crisis, and some investors do have the capacity to buy such deals, said Paul Mangione, a portfolio manager who recently left Apollo Residential Mortgage. Because Bayview’s deal was successful, others could follow suit, he added.

"Investors will take the time to look at these transactions now," Mangione said.

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